finance
Advanced Managerial Finance
In Ji Jang
Raising Capital
Ch.14,20
Raising Capital and Market Efficiency: Stock Price and NPV • Firm has no debt
• Existing assets generate earnings of $9mil. per year forever
• Discount rate=10%
• Firm has n shares (5 mil.) currently selling at P=$18 per share
Mkt. Value Balance Sheet Assets Equity Mkt Value V= E/R n shares x P0 =9/.10= 90 = 5 x 18 = 90
Share Price Effect of New Project • Now firm plans to invest I=$20mil. in a new project
• The project will generate $3 mil. in new earnings per year forever
• Firm will issue Δn new shares at price P0* to finance project
New Mkt. Value Balance Sheet Assets Equity Mkt Value
V= (9+3)/.10 = (5+n)P0* = 120 = 120
NPV and Share Price
• We would like to know the share price change with this new issue.
• NPV of the project:
• Wealth of original shareholders goes up by NPV of new project.
3 20 10
.10
E I
R
− = − =
*
0
*
0 0
*
0 0
*
0
9 3 120 * ( )
.10 .10
90 20
3 ( ) 20 10
.10
20; 5 ; 1
E E V n n P
R R
E V nP nP I
R
E n P P I
R
P n mil n mil
= = + = + = +
= = = = =
− = − = − =
= = =
Efficient market and shareholder wealth
• Expected return for new shareholders: EPS
Return
EMH
= $12mil / 6mil = 2
= EPS/Price = 2 /20 = 10%
→ Required return (discount rate) =10%
What if Market is Inefficient? • Suppose now new shares can only be sold for $18?
• How many new shares doe the firm needs to raise?
Company must sell $20mil./$18=1.111mil. new shares (total of 6.11 mil. shares after issuance)
• Eventually, company will be recognized to be worth $120 mil.
What would be the new price after the issuance?
Share price will rise to 120mil / 6.111mil =$19.636
Inefficient Market and Shareholder Wealth • After company value is recognized, and share price rises, original
shareholder gain (5mil. shares)*(19.636-18) = 8.182 mil
• New shareholder gain: (1.11mil) * (19.636-18)=1.818 mil
• Expected return for new shareholders: EPS = 12 / 6.111 = 1.964
Return = EPS/Price = 1.964/18 = 10.91% > 10%
(more than needed to attract capital)
Inefficient Market Transfers Wealth • Because new shares are sold too cheaply new shareholders gain
• At the expense of the original shareholders
• What happens if new shares can be sold at $22?
Timing of Securities Issues • If underpriced, new shareholders gain
• If overpriced, existing shareholders gain
Practice Problems
• Question 1